Killing it like a hooker in Hong Kong

The Toxic Asset Plan detail trial balloons are starting to be floated. This piece in the NYT has some preliminary details.

Basically, FDIC will provide leverage of 85% at something like 1% interest. Then FDIC will also chip in 12% of equity, and the private investor will put in 3% equity.

This is supposed to encourage the private investor to buy assets which are worth 30 cents on the dollar for the 60 cents that it’s marked on the bank’s book.

Devil in the details.

Basically I see only two ways this can play out, either A) It’s not going to work or B)It’s going to work, but produce massive profits for investors and massive losses for taxpayers… at the same time.

A) It’s not going to work

Because the investor still bears the first loss piece. So he is highly incentivized to pick and choose among the assets on offer and price them correctly. What happens when they hold the first auction and all the bids come in below the bank marks? Do you force the banks to sell? Or do you allow the banks to keep them on the book?

B) It’s going to work, but with massive losses for the taxpayer, and massive profits for private investors

This goes back to my earlier ringfencing post. Someone is going to figure out a structure so that assets can be segregated. Investors are going to punt, and they’re going to take the massive profits when they win, and leave everyone else saddled with losses when they lose.

Other considerations:

Special treatment: What happens if Treasure chooses say 5 firms, Blackrock, PIMCO, Western Asset Mgmt, Oaktree and Goldman. Won’t all the other firms scream bloody murder? Varde in Minnesota, Citadel in Chicago, Berkshire in Omaha? Each with it’s own congressional delegation making the appropriate noises? How are they not going to play favorites?

Spreading the wealth: Say due to the last point, anyone with say 50 mil under management gets to play. First it’s going to be an administrative nightmare, they’re going to be thousands of firms. Second, if the SEC didn’t know what Madoff was doing for 20 years, how are they going to keep track of this? What’s to prevent investors from playing games and money laundering and using derivatives to milk the taxpayer?

Is the money really out there? : Treasury seems to think that there’s 30 bill or more waiting to jump into this stuff. I doubt it. Firstly most of the private equity funds have far less money than the stated fund size. Secondly even if they could access it, they probably couldn’t draw all of it down in 1 go. It’s a practical matter because their investors are institutions like Harvard Management Company which simply don’t have liquid assets to fund PE commitments.

So where might the money come from? Foreign investors. That’s right. The guys holding the Treasuries who can put them into this. But it’ll have to be washed, so they’d pump money in through Blackstone or the other group.

Foreign governments are effectively going to assetize their US government debt, and end up owning large portions of the US economy.

To recap, Geither proposes that the Treasury will contribute, say 70%-90% of the funding required such toxic bank assets as long as unnamed hedge funds and private equity funds put in the remainder. Any loss that occurs would come out of the fund’s equity portion, before affecting the Treasury contribution.

Face value

This structure is essentially equivalent to having private investors contribute equity capital in a bank and having the government provide the deposits and unsecured debt. This would form the liability side of the balance sheet, and then the new shareholders would be incentivized to go out and buy bank assets. The key problem that this structure is supposed to resolve is that of price discovery: the private investors would have the incentive to price assets correctly in order not to lose their shirts.

As Mr. Geithner already knows from the AIG bailout, the devil is in the details, so here is an early preview of what could go wrong. Private investors will make a simple evaluation: Can I buy this toxic asset from a distressed bank, such that after whatever defaults may occur in the future, I will make a profit?

Cherry-Picking

The first thing I would do it cherry pick. I would go over a bank’s book, and wherever they have undervalued assets i.e. assets they have marked down already, but I think has a greater chance of recovery than they do, I would buy. This would load up the PPP bank with the higher quality assets, and leave the banks with lower quality assets. In return, the distressed banks will realize a profitbecause they sold the asset for a higher price than the mark.

Ring Fencing

The next thing I would do is ring fence, or play the odds. This is actually a typical private equity trick. Let’s say I have a 100 million dollars. I split that into ten vehicles, and have the Treasure give me 10:1 leverage on each vehicle. I have a billion dollars of firepower in 10 vehicles. I then make absolute punts with each vehicle, going for broke, buying stuff that no one else will buy. If each vehicle buys an asset at 30 cents on the dollar, and just one of the vehicles manages full recovery and all the others go bust, then for that one vehicle:

10mm equity+90mm debt = 100mm assets

after recovery

333mm assets = 90mm debt + 10mm interest + 233mm equity

My return on 10mm would be 2330% and on 100mm would 233%.

Most real banks are prevented from doing this because the Fed and FDIC has restrictions about how much risk they can take on the book, but the PPP vehicles will not.

My ring fence strategy would probably lose the Treasury a butt load of money, because they will lose money on all the other nine vehicles and won’t have recourse to my profitable tenth.

Every pundit has a different opinion on who is responsible for the credit crisis and the coming recession. From Kunstler who blames it on the Republicans, to Mish who includes Greenspan, to Feldstein who brings in the regulators.

I don’t think any of them deserve the blame.

My thesis is that the credit crisis and the coming recession are manifestations of a process that the entire world is responsible for. This narrative begins with the triumph of capitalism over communism in 1989, which reordered the world. As soon as capitalism became accepted as the only reasonable way of ordering the economic affairs of humanity, the warring between differing systems of capitalism began. On the one hand you have the laissez faire systems of the West and the developed countries and on the other you have the command economies of the East.

The Western system allows for individual decision making and political renewal but on the whole fails to reward long term planning by politicians. The Eastern system relies on catching up on development using methods already developed in the West while holding on fast to political power. Hence policy makers in the East are able to use their political strength to push unpopular long term goals because they have the utmost confidence in where their roadmap will lead.

The end result of the Eastern system is Japan. Once all catchup development has been done and new entrepreneurship is required, the Eastern system finds itself in crisis. Institutions which were not build to support individualistic thought find themselves struggling.

What does this have to do with the credit crisis? Well it all boils down to the savings rates of the fast growing East. With the amount of money being saved and invested in US dollar assets, there was essentially no way asset price bubbles of some sort would NOT have formed in the US. That is why the bubble moved from Internet stocks to home prices and then to all forms of debt. There is essentially no way that the Fed could have prevented this without some rather drastic measures, like for example restricting US dollar convertibility.

So when the tide of liquidity rose, there was bound to leaks, bridges swept away, land inundated, and when the levees broke, it should not have come as a surprise that a flood of biblical proportions emerged.

Great article from George Soros about the current state of affairs. Seems like he believes the 6% gain in my portfolio from mid March is a true dead cat bounce. I think another 6 months is going to bring us to the proper brink of the crisis. We’ll see.

The proposal from Hank Paulson, US Treasury secretary, for reorganising government regulation of financial institutions misses the point. We need new thinking, not a reshuffling of regulatory agencies. The Federal Reserve has long had authority to issue rules for the mortgage industry but failed to exercise it. For the past 25 years or so the financial authorities and institutions they regulate have been guided by market fundamentalism: the belief that markets tend towards equilibrium and that deviations from it occur in a random manner. All the innovations – risk management, trading techniques, the alphabet soup of derivatives and synthetic financial instruments – were based on that belief. The innovations remained unregulated because authorities believe markets are self-correcting.

Regulators ought to have known better because it was their intervention that prevented the financial system from unravelling on several occasions. Their success has reinforced the misconception that markets are self-correcting. That in turn allowed a bubble of excessive credit to develop, which extended through the entire financial system. When the subprime mortgage crisis erupted it revealed all the weak points. Authorities, caught unawares, responded to each new disruption only after it occurred. They lacked the ability to foresee them because they were in the thrall of the market fundamentalist fallacy. They need a new paradigm. Market participants cannot base their decisions on knowledge, or what economists call rational expectations. There is a two-way, reflexive interaction between the participants’ biased views and misconceptions and the real state of affairs. Instead of random deviations, reflexivity may give rise to initially self-reinforcing but eventually self-defeating boom-bust sequences or bubbles.

Instead of reshuffling regulatory agencies, the authorities ought to prepare for the next shoes to drop. I shall mention only two. There is an esoteric financial instrument called credit default swaps. The notional amount of CDS contracts outstanding is roughly $45,000bn. To put it into perspective, that is about equal to half the total US household wealth and about five times the national debt. The market is totally unregulated and those who hold the contracts do not know whether their counterparties have adequately protected themselves. If and when defaults occur, some of the counterparties are likely to prove unable to fulfil their obligations. This prospect hangs over the financial markets like a sword of Damocles that is bound to fall, but only after some defaults have occurred. That must have played a role in the Fed’s decision not to allow Bear Stearns to fail. One possible solution is to establish a clearing house or exchange with a sound capital structure and strict margin requirements to which all existing and future contracts would have to be submitted. That would do more good in clearing the air than a grand regulatory reorganisation.

The other issue is rising foreclosures. About 40 per cent of the 6m subprime loans outstanding will default in the next two years. The defaults of option-adjustable-rate mortgages and other mortgages subject to rate reset will be of the same order of magnitude but occur over a longer period. With single family home sales running at an annual rate of 600,000, foreclosures will overwhelm the market and cause prices to overshoot on the downside. This will swell the number of homeowners with negative equity who may be tempted to turn in their keys. The fall in house prices will become practically bottomless until the government intervenes. Cutting foreclosures should be a priority but the measures so far are public relations exercises.

The Bush administration has resisted using taxpayers’ money because of its market fundamentalist ideology. Apart from a bipartisan fiscal stimulus, it has left the conduct of policy largely to the Fed. Yet taxpayers’ money will be needed to reduce foreclosures. Two proposals by Democrats in Congress strike a balance between the right to foreclosure and discouraging the exercise of that right. One would modify the bankruptcy laws allowing judges to modify the terms of mortgages on principal residences. Another would provide Federal Housing Administration guarantees that would enable mortgage holders to be paid off at 85 per cent of the current appraised value. These proposals will not solve the housing crisis, but go to the heart of the issue. They should be given serious consideration.

The writer’s book, The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What It Means, is released as an e-book by PublicAffairs on Thursday

About

Paul Delima is a bouncing ball of energy. He is exuberation personified. Paul Delima lives between Shanghai and Jakarta, speaks four languages and breathes economics like others snort coke.

He is overqualified, overpaid, underworked, and takes great pleasure for calling bullshit when he sees it.

He likes receiving non-spam comments.

Paul Delima is originally from Southern California, and graduated from Harvard without honors in 1997. He moved out to Hong Kong and worked for an investment bank, got a CFA along the way, rode out two Asian downturns, and joined a hedge fund.

Paul Delima now does Asian bankruptcy work, and has an active interest in distressed firms of all kinds.